Retirement Planning

In General

Which would you rather have, a $1,000,000 or a penny doubled every day for a month?  If you picked the $1,000,000, you would have short-changed yourself by over $9,000,000.  This simple example profoundly illustrates the miracle of compounding interest: that is, a principal amount of money earns interest, thus growing the principal on which more interest will later be earned.  If we have enough cycles in which the principal amount doubles in value, the miracle of compounding interest becomes more and more pronounced as noted in the above Example.

The rule of 72's gives us an excellent standard to determine the doubling period.  For example, if a principal sum is earning a fixed rate of interest of 6%, that sum will double in value in approximately 12 years (72 divided by 6 equals 12).  If the principal sum is earning interest at a rate of 12%, it will take only 6 years for the principal sum to double in value (72 divided by 12 equals 6).  Divide other interest rates into 72 and observe the time required to double your initial principal.

Historically, those who have invested in well-diversified stock mutual funds (described below) have had an average rate of return in the 12% range.  The longer the investor has before retirement, the more assured he or she is of attaining or exceeding that historic average.  Conversely, a 6% rate of return would be closer to an historic average for a class of investments traditionally deemed safer, such as well-rated corporate bonds, certificates of deposit and U.S. bonds and notes.

If I am a 24-year-old worker who desires to retire at age 60 and I invest in stock funds, per the earlier analysis, a dollar I invest at age 24 that averages a 12% rate of return will double six times by the time I reach age 60.  That dollar thus becomes $64 ($1 becomes $2 becomes $4 becomes $8 becomes $16 becomes $32 becomes $64).  Conversely, the investor putting his or her money in a safer form of investment earning a 6% rate of return will find that same dollar invested at age 24 doubling about three times to $8 ($1 becomes $2 becomes $4 become $8).

You see from these illustrations a few fundamentally important concepts in our retirement planning: Concept One - the earlier in life you begin your retirement planning the vastly better off you are, and, Concept Two - the higher the average rate of return, the more powerful the compounding interest effect.  We will talk about the trade-off between higher rates of return and the risk inherent in the investment later on in this section of the book, but let's leave it for now by stating that the younger you are and the more time you have until retirement, the more risk you should take in your investments.  Why?  Because the highs and lows average out over time on riskier investments and the younger investor optimizes the two concepts I just mentioned.

But what I've just illustrated for you presupposes that you've already made the decision to invest and the only question is the form of investment.  What if you are like the person I was, always making excuses for not beginning to fund a retirement plan.  I had plenty of excuses such as six children, a wife who was at home with the kids and not generating an income, etc.  I did not begin meaningfully funding my own retirement plan until just a few years ago, when I was in my early 40's.  Late is certainly better than never, but I cut my own throat by not optimizing two decades of the most powerful compounding years by not beginning to invest in my 20's.  And by the way, I realized an amazing thing when I did start my investment program: I didn't really notice the absence of the money I was investing in terms of it degrading my lifestyle.  That has been the case even though what I have and will sock away will hopefully grow to about a million dollars by the time I retire in 15 or 20 years.

One other very important point that you'll see illustrated.  Taxation will gut our investment's rate of return if it is a currently taxable investment.  All the investment options that I will focus on, however, are tax-favored forms of investment where the taxes generally are not due until you retire and start drawing on the wealth, or in a more limited situation, are never taxed at all.